Lec 7 - The Business Cycle, Inflation & Deflation

Question 1

Business cycle definition

Answer 1

Fluctuations of real GDP around potential GDP.

Increase in potential GDP (whether due to labour, technology, capital) brings expansion.

Question 2

Inflation cycle definition

Answer 2

Fluctuations of price level.

Question 3

Business cycle approaches

What are the two main approaches to understanding business cycle theory?

Answer 3

Two approaches to understanding business cycle theory:
Mainstream business cycle theory
Real business cycle theory

Question 4

Mainstream business cycle theory

Answer 4

Because potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.

Within mainstream business cycle theory, there are different views as to why this is the case: the monetarist view is that AD grows at a varying pace because of money supply.

Question 5

Business cycle with AS-AD

What happens if AD increases more slowly than potential GDP?

Answer 5

During an expansion, aggregate demand increases and usually by more than potential GDP.

Assume that during this expansion the price level is expected to rise and that the money wage rate was set on that expectation.

The price level rises as expected.
But if aggregate demand increases more slowly than potential GDP, the AD curve shifts to AD2.
Real GDP growth is slower; inflation is less than expected.

Question 6

Business cycle with AS-AD

What happens if AD increases more quickly than potential GDP?

Answer 6

If aggregate demand increases more quickly than potential GDP, the AD curve shifts to AD3.
Real GDP growth is faster; inflation is higher than expected.

Question 7

What does the relentless increase in potential GDP cause?

Answer 7

Economic growth, inflation and the business cycle arise from the relentless increase in potential GDP, faster (on average) increases in aggregate demand, and fluctuations in the pace of aggregate demand growth.

Question 8

Causes of business cycles and recessions

Answer 8

One point of contention among economists is the causes of business cycles and recessions.

And if you disagree on the causes, chances are that you disagree on the solutions.

Question 9

Real business cycle theory

Answer 9

Random fluctuations in productivity are the main source of economic fluctuations.

Productivity fluctuations are assumed to result mainly from fluctuations in the pace of technological change.

Other sources: international disturbances, climate fluctuations or natural disasters.

RBC impulse = productivity growth rate

Most of the time, technological change is steady.

But sometimes productivity growth speeds up, and occasionally it decreases.

Question 10

RBC impulse definition & effects

Answer 10

A period of rapid productivity growth brings an expansion, and a decrease in productivity triggers a recession.

There are two effects which follow a change in productivity that gets an expansion or a contraction going:
Investment demand changes.
The demand for labour changes.

Question 11

RBC impulse - effect of productivity on investment

Answer 11

A decrease in productivity decreases investment demand, which decreases the demand for loanable funds.

The real interest rate falls and the quantity of loanable funds decreases.

Question 12

The decision of when to work

Answer 12

To decide when to work, people compare the return from working in the current period with the expected return from working in a later period.

The when-to-work decision depends on the real interest rate.

The lower the real interest rate, the smaller is the supply of labour today.

Many economists believe that this intertemporal substitution effect is small, but RBC theorists believe that it is large and the key feature of the RBC mechanism.

Question 13

Effect of a decrease in productivity on demand for labour

Answer 13

Figure shows the effects of a decrease in productivity on demand for labour.

A decrease in productivity decreases the demand for labour.

The fall in the real interest rate decreases the supply of labour.

Employment and the real wage rate decrease.

Question 14

RBC criticism and defense

Answer 14

The money wage rate is sticky, and to assume otherwise is at odds with facts.
Intertemporal substitution is too weak a force to account for large fluctuations in labour supply and employment.

Paul Krugman argued that this assumption would mean that 25% unemployment during Great Depression (1933) would be the result of a mass decision to take a long vacation.

RBC theory explains facts about the business cycle and is consistent with economic growth.
RBC theory is consistent with a wide range of microeconomic evidence about labour supply decisions, labour demand and investment demand decisions.

Question 15

Cause of inflation

What is the cause of inflation in the long run and short run?

Answer 15

In the long run, inflation occurs if the quantity of money grows faster than potential GDP.

In the short run, many factors can start an inflation, and real GDP and the price level interact. We distinguish two (short run) sources of inflation:
Demand-pull inflation
Cost-push inflation

Question 16

Demand-pull inflation definition

Answer 16

Demand-Pull inflation may begin with an increase in any factor that increases aggregate demand (AD), such as: quantity of money, government expenditure, exports.

Question 17

Cost-push inflation definition

Answer 17

Cost-Push inflation results from an initial increase in costs: money wage rate, money price of a raw material (oil).

Question 18

Demand-pull inflation in practice

What is the initial effect of an increase in Aggregate Demand?

Answer 18

Starting from full employment, an increase in aggregate demand shifts the AD curve rightward.

The price level rises, real GDP increases and an inflationary gap arises.

The rising price level is the first step in the demand-pull inflation.

Question 19

Money wage rate response to demand-pull inflation

Answer 19

The money wage rate rises and the SAS curve shifts leftward.

The price level rises and real GDP decreases back towards potential GDP.

As the money wage rate continues to rise, the SAS curve shifts further leftward.

Real GDP decreases back to potential GDP but the price level rises further.

Question 20

Demand-pull inflation spiral

Answer 20

Aggregate demand keeps increasing and the process just described repeats indefinitely.

Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.

Question 21

Cost-push inflation

What is the initial effect of a decrease in aggregate supply?

Answer 21

A rise in the price of oil shifts the SAS curve leftward.

Real GDP decreases and the price level rises.

The rising price level is the start of the cost-push inflation.

Question 22

Aggregate demand response to cost-push inflation

Answer 22

The initial increase in costs creates a one-time rise in the price level, not inflation.

To create inflation, aggregate demand must increase.

That is, the Bank of England must increase the quantity of money persistently.

The Bank of England might stimulate demand.

The price level rises again and real GDP increases.

Question 23

Cost-push inflation spiral

Answer 23

If the oil producers raise the price of oil and the Bank of England responds with an increase in aggregate demand, a process of cost-push inflation continues.

Question 24

Stagflation definition

Answer 24

The combination of a rising price level and a decreasing real GDP.

Question 25

Expected inflation

Answer 25

Aggregate demand increases, but the increase is anticipated, so its effect on the price level is expected.
It can thus be factored in to the wages.

Question 26

Forecasting inflation

Answer 26

To anticipate inflation, people must forecast it.
The best forecast available is one that is based on all the relevant information and is called a rational expectation.
A rational expectation is not necessarily correct, but it is the best available.

Question 27

Forecasting inflation - effect of different outcomes

Answer 27

When the inflation forecast is correct, the economy operates at full employment.
If aggregate demand grows faster than expected, real GDP moves above potential GDP, the inflation rate exceeds its expected rate, and the economy behaves like it does in a demand-pull inflation.
If aggregate demand grows more slowly than expected, real GDP falls below potential GDP, the inflation rate slows, and the economy behaves like it does in a cost-push inflation.

Question 28

Misery Index

Answer 28

Low inflation, low unemployment and rapid income growth is ideal.

In the 1970s, when inflation was raging at a double-digit rate, Arthur M. Okun proposed a Misery Index:
Misery Index = inflation rate + unemployment rate

Question 29

Limitations of misery index

What are the four main limitations of this model?

Answer 29

There are a number of limitations of this model:
Arguably UK unemployment is underestimated.
Deflation is worse than inflation. Therefore, inflation of 0% may suggest a stagnant economy like Japan in the 1990s, but gives a low misery index.
Inflation may be temporary, e.g. due to cost push factors.
Costs of unemployment arguably greater than inflation – it depends on factors like real interest rates which determine real value of savings.

Question 30

Life satisfaction and misery index variables

Answer 30

Inflation and unemployment are not equal. Unemployment is more detrimental to happiness than inflation.

Question 31

Phillips curve definition

Answer 31

A curve that shows the relationship between the inflation rate and the unemployment rate.

Question 32

Short run Phillips curve

Answer 32

The relationship between inflation and unemployment, holding constant:
The expected inflation rate
The natural unemployment rate

Question 33

Long run Phillips curve

Answer 33

The relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate.

Question 34

Short run Phillips curve in practice

Answer 34

It passes through the natural unemployment rate and the expected inflation rate.

With a given expected inflation rate and natural unemployment rate:

If the inflation rate rises above the expected inflation rate, the unemployment rate decreases.

If the inflation rate falls below the expected inflation rate, the unemployment rate increases.

Question 35

Long run Phillips curve in practice

Answer 35

The Long-run Phillips curve (LRPC) is vertical at the natural unemployment rate.

Along the long-run Phillips curve, because a change in the inflation rate is anticipated, it has no effect on the unemployment rate.

Question 36

Phillips curve in practice - changes in expected inflation rate

Answer 36

Short-run Phillips curve shifts when the expected inflation rate changes.

A lower expected inflation rate shifts the short-run Phillips curve downward by an amount equal to the fall in the expected inflation rate.

Question 37

Phillips curve in practice - changes in natural unemployment rate

Answer 37

A change in the natural unemployment rate shifts both the long-run and short-run Phillips curves.